Inflation estimate errors costing defined benefit sponsors £50 billion

Overestimated inflation projections could be costing UK defined benefit scheme sponsors more than £50 billion in unnecessary funding commitments, a corporate adviser warns

Estimates used by trustees to judge future inflation are 1% higher than actual levels of inflation – distorting the estimate of scheme deficits, says PricewaterhouseCoopers (PwC) today.

This, along with falling stock markets and gilt yields, has compounded the severe funding problems seen by corporate pension schemes.

PwC's London-based pensions actuarial practice head Raj Mody (pictured), says: "While pension schemes tend to make a small deduction to market-derived inflation models, say up to 0.25% per annum, our analysis suggests this still leaves a significant overstatement in likely pension scheme liability values.

"Having that margin for prudence may well be the right thing to do, as long as all parties understand what's going on. But sometimes it may not be necessary to be quite so prudent, including in schemes where the impact of higher inflation may, in any case, be partly offset by higher investment returns. The point is, you need to analyse each pension scheme's profile and not just follow the herd."

Mody added that the findings made a strong case for reviewing how pension schemes deal with all aspects of their exposure to inflation. Trustees have traditionally used 'market implied' inflation to judge their liabilities and assets, which is determined from the difference between market yields on fixed-income and index-linked gilts.

PwC tracked market-implied inflation projections over historic periods against actual Retail Prices Index inflation and found them to be 1% higher a year. This could be leading schemes to factor in additional funding of £50 billion more than they need.

However, Jonathan Camfield, a partner at consultants Lane Clark & Peacock, based in London, cautioned against looking at one assumption in isolation. "An actuarial valuation involves a lot of assumptions and internal consistency between them all is important. Market-based valuations are widely used now in the financial community and pension schemes move away from that approach at their own peril," he says.

"It would be easy to pick on other assumptions and show that historically, the assumption adopted had been particularly prudent or particularly not prudent, because you're always going to get volatility. I think that misses the point. It is ensuring that all the assumptions are consistent at each valuation date, which is the most important thing."

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